Agents and advisers already know that the interest rate offered by traditional fixed-rate annuities is frequently higher than that from bank CDs that have similar holding periods. It also is well known within the financial services community that the interest from a CD is currently taxable while interest from an annuity is tax deferred indefinitely and only becomes taxable when withdrawn. This article explores the differences between the protection afforded by annuities versus bank certificates of deposit.
The FDIC is an independent agency of the U.S. government. The agency protects depositors up to $100,000 per account if an FDIC-insured bank or savings and loan association fails. Depositors can have more than one $100,000 insured account, as long as each account meets certain requirements, such as a different legal ownership for each.
Not all banks are FDIC insured; FDIC membership can be verified by calling the FDIC at (800) 934-3342 or by going to its Web site at www2.fdic.gov/idasp. From 1994 to 2003, 62 banks failed. Customers of FDIC-insured banks were protected up to the $100,000 limit per account, but those with balances above $100,000 experienced something different. The amount of uninsured deposits that are reimbursed is based on the sale of the failed bank's assets. The sale of such assets can take years, and the depositor usually is not made whole. As an example, 18 banks failed in 2001 through 2003. Of the banks that completed receivership by 2004, CD investors received 65 to 95 cents on the dollar.
Each state, as well as the District of Columbia and Puerto Rico, has a life and health insurance guaranty association that protects annuity owners if an insurer becomes insolvent. Before an insurance company can do business in a state, it is required to join the state's guaranty association. In the event an insurer becomes insolvent, the other insurance companies doing business in the state that are involved in the same kinds of insurance must bail out the insolvent member.
Insurance guaranty association coverage limits vary from state to state, but all states must provide at least $100,000 of protection per contract for withdrawals and cash values for fixed-rate annuities, health insurance, and life insurance policies. As of the end of 2005, every annuity owner of a failed company was given the option of having the contract assumed by another insurance company or having the covered portions fulfilled by the guaranty association.
From 1994 through 2003, 31 life insurance companies (all of which issue annuities) became insolvent; every state guaranty association provided at least $100,000 of coverage per contract owner. Of the 31 insolvent companies, only three did not provide 100% coverage for all of their annuity contract owners, even those with account values in excess of $100,000.
State Guaranty Associations
Each state has a guaranty association that provides protection for life insurance, health insurance, and annuity owners. Created by state law, it provides limited protection to policyholders when an insurance company licensed to do business in the state becomes insolvent.
Protection can be provided in several different ways. For example, the guaranty association may provide coverage directly. Or, a financially sound insurer may take over the insolvent company's assets and policies and assume responsibility for continuing coverage and paying covered claims.
The maximum amount of protection for which the guaranty association may become liable for life insurance and annuity policies varies by state. For example, protection in California is as follows: Life insurance death benefit protection -- 80% of the policy death benefit up to a maximum of $250,000; life insurance net cash surrender and net cash withdrawal values -- 80% of the policy value up to a maximum of $100,000. In the case of annuity contracts, the protection is 80% of the present value up to a maximum of $100,000.
Usually, states have imposed an interest rate reduction when an insolvent insurer promised a rate of interest in excess of that provided for by the state association. In California, the maximum total benefit paid out for one individual for life insurance and annuity coverage is $250,000, even if that individual is covered by multiple life insurance policies and annuities. An example will help clarify coverage.
Suppose each spouse has an annuity contract worth $75,000. In this example, each spouse would have separate protection. The couple would have combined total protection of up to $120,000 (80% of $75,000 for each). Interest rate adjustments could further reduce the amount they would be entitled to recover.
Agents are prohibited from promoting the state guaranty associations as a product feature. By talking to your supervisor or compliance officer, however, there may be a way to educate the prospect or existing client. For example, you may be able to say something like: "Mrs. Smith, before making a decision, you may want to go to the Web page for the state's insurance department. This Web site contains valuable information that may be useful for you to have before making a decision."
Social Security Concerns
Married couples with an adjusted gross income (AGI) greater than $44,000 ($25,000 for singles) are subject to having anywhere from 50% to 85% of their Social Security benefits taxed as ordinary income. Even with careful planning, investors can find themselves subject to such taxation.
The interest earned from a CD is taxable each year whether or not it is received. Such interest could make an individual or couple's Social Security benefits taxable. With an annuity, this is never an issue or concern because the investor decides if, when, and how much to withdraw from an annuity -- annuities do not have capital gains distributions. But what can be done if the annuity investor needs current income?
A simple strategy is to "bunch up" income, thereby making Social Security benefits partially taxable every two or three years. For example, suppose Mr. and Mrs. Smith need $15,000 of interest income each year and already have an AGI that is approximately $44,000. If the couple only had CDs that annually accrued $15,000 of interest, their Social Security income would be taxable each year.
If, instead, the couple owned an annuity that accrued the same $15,000 each year, the couple could wait and take out $30,000 every other year and use half of the $30,000 for each of the next two years for current income. By doing this, Social Security benefits would be taxable only every other year (or once every three years if $45,000 were taken out). By "bunching up," the couple can save a few to several thousand dollars in income taxes every other year.
Rarely Mentioned Benefits
Every time someone invests in a CD or rolls over a CD, another penalty period is created. With an annuity, as long as you stay with the same product and carrier, there is no recurring penalty period. The annuity owner can continue the investment after the initial penalty period without any new or future penalty.
The annuity investor also has a "30-day free-look period"; CD buyers are not afforded a similar grace period. During this 30-day period (60 days in some states), the contract owner is guaranteed that he or she can cancel the contract and receive back 100% of the principal. The clock starts on the day the contract is received by the annuity owner.
Finally, CDs are considered to be only accumulation vehicles; annuities are designed for accumulation and distribution. Lifetime, joint and survivor, period certain, term certain, and specific dollar payout options are available only with an annuity.
Gordon K. Williamson, JD, MBA, CFS, CAS, CLU, ChFC, AEP, a former tax and estate planning attorney, is the author of more than 30 books, including The 100 Best Mutual Funds You Can Buy, which has sold more than 500,000 copies. Mr. Williamson has been the financial editor of a number of magazines and newspapers. He is the executive director and founder of the Institute of Business & Finance, a nonprofit educational provider to the financial services industry.
